Despite winning the Nobel Prize in Economics, Oliver Williamson’s name is often unrecognized among Berkeley’s student population – which is a shame because of the man’s tremendous insights and revolutionary approach to economics. His work defines the field of transaction cost economics, reshaping how we understand business practices and carry out regulations, particularly anti-trust regulations.
Williamson’s approach to economics is quite refreshing. Rather than the “rationalist” approaching economics with rigorous mathematics and thought experiments, Williamson is a devout empiricist with very little regard for untested theory and uncritical ideology. He described observing a conference in which the late Nobel Laureate Milton Friedman presented the results of the first empirical tests of Keynesian monetary theories such that Friedman “had the data on his side,” and was able to stand “against the whole world,” demonstrating the errors of Keynes’ theories using cold, hard data instead of elegant mathematics or debatable logical arguments. Williamson’s view of economics allows for the omission of rigorous mathematical models and demands a high degree of empirical validation – both, as he says, “breaths of fresh air” in the field. The approach has served him well, allowing him to analyze economic phenomena in a far richer context than can be examined by mathematical models, while his ivory tower colleagues generate theories divorced from reality.
The particular course of Williamson’s work was set while he was on leave in Warrick, where he read about an economist of the 1930’s – not Keynes – who influenced him greatly. That man, John R. Commons, took exception to what Williamson calls “the resource allocation paradigm,” the traditional view that characterizes firms as single actors responding to prices and demand schedules to produce and deliver the optimal quantity of goods and services. While this can often be useful, it reduces economics essentially to calculus problems, as any student in the Econ 101 series can attest to. This approach tends to dehumanize core issues and dismiss the rich context that gives rise to particular solutions to economic problems, hence Williamson’s criticism of the “firm as production function” model of economics.
Commons believed that the concept that economics should be founded upon was one that can find a way to combine “conflict, mutuality, and order.” The study of governance thus addresses the “means to infuse order, mitigate conflict, and realize mutual gain.” Commons, and Williamson, take this fundamental economic unit to be, not firms, but transactions. Unfortunately, Commons never found a way to give transaction costs what Williamson describes as “operational content”; Commons was unable to formulate a model, verbal or mathematical, and so was unable to give transaction cost economics sufficient momentum.
Central to Williamson’s work is a study of contracts. One aspect of this is the broken contract: someone simply does not cooperate, or there is an honest disagreement that can harm a party who made an investment that can’t be easily liquidated or redeployed – a characteristic he terms asset specificity, which has itself redefined how we think about economics. Traditional solutions to broken contracts include information disclosure rules and auditing to ensure more complete information and thus more appropriate contracts, or penalty clauses to discourage breach of contract. Says Williamson, “if push comes to shove, we get a special dispute system to arbitrate – not the courts – whose objective is to get back on track, not to extract wealth punitively.” Such an arbitration system produces order, deters conflict, and promotes harmony and mutual gain. Williamson describes this process as “a way to think about contracts in a constructive, not legalistic, way.”
To analyze contracts, we must be able to describe the organizations that make them. Both Chester Barnard and Friedrich Hayek described organization as a tool to facilitate adaptation. Barnard, a management theorist, took adaptation to mean deliberate, purposeful, and coordinated changes – the kind that define a “hierarchy,” or a heavily structured organization. Hayek, a Nobel prize-winning Austrian economist, instead framed adaptation within the context of relatively disorganized markets, with signals such as prices communicating information that people adjust to autonomously to re-equilibrate the system and restore order.
Williamson is dissatisfied with choosing either of the two views, as each has strengths and weaknesses that make them more suited to certain contexts than others. His work attempts to characterize these governance structures and determine which one makes transactions more efficient, in which contexts, and why.
He is also quick to point out the range of phenomena the transaction-cost and governance approach to economics can explain. Williamson’s work has touched economic and administrative issues such as credit versus equity financing – redeveloping finance in constructive ways – to anti-trust laws and business regulations – providing information on the contexts in which these laws don’t work, and suggesting alternative strategies that promote harmony and mutual gain.
His work in anti-trust alone has forced countries across the globe to rethink what economic ends they pursue and how they do so. Williamson, as the Special Economic Assistant to the head of the Anti-Trust division within the US Department of Justice, noted how classic economic theory did not appropriately respond to monopolies; the DoJ had, in his mind, “the wrong perspective.” After Williamson, vertical integration (where a company owns all stages of production, such as a power plant owning a railroad line and a coal mine) is no longer itself a justification for anti-trust suits. He showed how this arrangement in fact stabilizes and lowers prices by making supply more consistent and efficient. He has also criticized anti-trust leveled at companies whose sole fault is that they are big, regardless of their efficiency. As economist Thomas Sowell observed, even 100% market share does not make a monopoly – the company has to be doing things directed at keeping the competition out, and selling more for less isn’t a legitimate claim for “anti-competitive” business. The notion that we should have competition for competition’s sake has only resulted in wasted resources and losses to consumers.
His work in the anti-trust field has even led to the reconsideration of how we evaluate the monopolistic nature of companies. In one such memorable case, large oil companies had contracts with each other to buy and sell from each other in particular regions. When one oil company ran a shortage in one area, a second company would supply the necessary oil from its surplus. The first would then supply the second oil at another region. At first this seems to be a scheme to keep the little guy out and entrench the large oil producers. But internal company memos defended the policy by indicating that small suppliers characteristically have minimal investments in a given region, increasing the likelihood that they will not be able to fulfill long term contracts, thereby increasing the volatility of supply and prices. The “monopolistic” actions of the company were in fact intended simply to promote order in the marketplace, to the benefit of both consumers and the economy at large. Empirical evidence like this has at least partially restored the presumption of innocence in the legal system, even (and especially) for business.
Perhaps most importantly, Williamson has demonstrated that decentralized, voluntary associations are viable “governance structures” and that government management of the economy is often neither necessary nor desirable. For all of his many achievements over the course of his long and distinguished career, Oliver Williamson deserves to be saluted.